Foreign Exchange Risk Management Dr Michael Dowling Day 4

Today Basics Forwards Futures Options Applied Calculating exposures Hedging strategies

The Dojimakomekaisho origins of derivatives  1697: founding of rice market in Dojima, Osaka. First recorded derivatives market.  Benefits for:  Farmers?  Wholesalers?  Speculators?

Forwards - and an introduction to the concept of derivatives

The forward market  While the spot foreign exchange market is for the immediate exchange of currencies, the forward market involves contracting today for the future purchase or sale of foreign exchange  Forward market price for a currency are usually higher (at a premium) or lower (at a discount) than the spot market

Forward price quotes Spot price terminology: Forward price terminology: S($/SF) F 1 ($/SF) F 3 ($/SF) F 6 ($/SF) SF trading at a premium to $

Trading Example A $/SF trader has just heard an economic forecast that causes him to believe that the dollar will likely appreciate in value against the Swiss franc over the next three months. Long / short (buy/sell short) the $/SF 3- month contract?

… short the $/SF 3-month  Assume he sells SF5,000,000 forward against dollars. Price F 3 ($/SF) is  In 3 months spot price is $ Profit / loss? How much?  In 3 months spot price is $ Profit / loss? How much?

Calculating forward premium or discount Common to calculate premium or discount as an annualized percentage deviation from the spot rate

E.g. calculate $/Y premium or discount S($/¥) F 3 ($/¥)

Futures - a formalized version of forwards

A standardized version of a forward  Traded on exchanges  Specified contract sizes and maturity dates  Daily margin requirements

Some real data € contract size = €125,000

Options - and now for something quite different (using regular stock options to explain, as currency options a bit complicated for first options introduction, but we’ll look at forex examples next week)

Some option terminology  Buy – “to go long”  Sell – “to go short”  Call optionright to buy  Put optionright to sell Key Elements  Exercise or Strike Price price at which contract will be settled  Premium or Pricepurchase price  Maturity or Expirationdate option ends

Example of a call option (using stocks instead of currencies) You buy an April call option in IBM stock with exercise price of $95 This means that you have the right to buy IBM stock for $95 per share at any time until the expiration date in April You will only choose to buy the stock if the market price of the stock becomes higher than $95. You do not have to buy the stock if the price is less than $95.

Some more details on that last example  You would have bought the option from an option writer  An option writer (usually a big bank) makes money from the purchase price or premium they receive  They have the risk that they might be forced to buy shares in the stock market at a high price and sell them to the call option purchaser at the agreed exercise price  In most circumstances you will just receive the difference between the higher price and the exercise price [your profit] – rather than actually buying the shares you have the call option on.

Market and Exercise Price Relationships In the Money: exercise of the option would be profitable Call:market price > exercise price Put:exercise price > market price Out of the Money: exercise of the option would not be profitable Call:market price < exercise price Put:exercise price < market price At the Money: exercise price and asset price are equal

Two main types of option contracts American options: the option can be exercised at any time before expiration or maturity European options: the option can only be exercised on the expiration or maturity date American options are what we are discussing today

Payoffs and profits on options at expiration – Call Options Notation Stock Price = ST Exercise Price = X Payoff to Call Holder (ST - X) if ST > X 0if ST < X Profit to Call Holder Payoff minus Purchase Price Payoff is the value of the option at expiration

Example You hold a call option on Fin Corp stock with an exercise price of $80. Fin Corp is selling at $90 at expiration You exercise the option and make a profit of $90 - $80 If the price was below $80 then you wouldn’t exercise the option If the call option cost $14 then you would make a profit of $10 - $14 = -$4 Why would you exercise an option when you were going to make a loss?

Payoff and profit to call option at expiration [purchaser]

Payoffs and profits on options at expiration – Call Options Payoff to Call Writer - ( S T - X) if S T >X 0if S T < X Profit to Call Writer Payoff plus Premium From the previous example, the call writer would have made a profit of -$10 + $14 = $4

Payoff and profit to call option at expiration [Call Writer]

Payoffs and profits at expiration – Put Options Payoffs to Put Holder 0if S T > X (X - S T ) if S T < X Profit to Put Holder Payoff minus Premium

Payoffs and profits at expiration – Put Options Payoffs to Put Writer 0if S T > X -(X - S T )if S T < X Profits to Put Writer Payoff plus Premium

Payoff and profit to Put Option at expiration [purchaser]

Applied Hedging

Transaction exposure… When a firm has foreign- currency-denominated receivables and payables, it is subject to transaction exposure

How do we handle this risk? Forward market hedge Money market hedge Option market hedge Swap market hedge Financial Contracts Choice of invoice currency Lead/lad strategy Exposure netting Operational Techniques

Financial Contracts

An example we’ll use to illustrate the different financial contract techniques US-based Boeing sell a Boeing 747 to British Airways and bill £10 million payable in one year US interest rate6.10% per annum UK interest rate9.00% per annum Spot exchange rate$1.50/£ Forward exchange rate$1.46/£ (1 year maturity)

Forward Market Hedge  Where a firm sells (buys) its foreign currency receivables (payables) forward to eliminate its exchange risk exposure  Boeing sells forward its £10m receivable in exchange for a given amount of dollars  On maturity date of contract, Boeing will deliver the £10m received from BA and take delivery of $14.6m ($1.46 x 10 million)  Forward ensures that a certain amount of dollars will be received

Issues to consider  Giving up any potential gains from dollar appreciation higher than expected  Even if BA cannot pay the £10m they will be contractually obliged to pay the money  Willingness to engage in forward hedging will be determined by degree of risk aversion  Paying for the risk to be removed; insurance. Would e.g. Microsoft want to hedge all forex risks in this way?  Will be interim cash flows that have to be paid due to marking-to-market

Money Market Hedge  Hedging by lending and borrowing in the domestic and foreign money markets  Firm borrows (lends) in foreign currency to hedge its foreign currency receivables (payables), thus matching its assets and liabilities in the same currency  If the implied interest rate in the forward contract is the same as the actual interest rates in the two countries, then there will be no difference in amount received under money market and forward hedging

Step-by-step money market hedging Step 1 Borrow £9,174,312 in the UK (£10m divided by UK interest rate of 9%) Step 2 Convert £9,174,312 into $13,761,468 at the current spot exchange rate of $1.50/£ Step 3 Invest (bank) $13,761,468 in the US Step 4 Collect £10m from BA and use to repay the pound loan which is now £10m Step 5 Receive the maturity value of the dollar investment i.e. $14,600,918 ($13,761,468*1.061) Interest rate should be adjusted for length of contract. E.g. if 6 months then divide by 2

Options Market Hedge  Forward and money market hedges completely eliminate exchange exposure; however this then removes the opportunity to benefit from favourable exchange rate movements  It also commits us to the exchange, which might not always be appropriate  Options provide more flexibility in our hedging, as well as allowing us to benefit from favourable forex movements

Applying this to Boeing

More on option hedging  Limits the downside risk while preserving the upside potential  However it is the only of the three hedging strategies that has an upfront cost, so you are paying for the upside potential  If we had an account payable instead of a receivable then we would buy a call option

The flipside: hedging when we have to pay money in a foreign currency US-based Boeing agree to buy a Rolls Royce jet engine for £5 million payable in one year US interest rate6.00% per annum UK interest rate6.50% per annum Spot exchange rate$1.80/£ Forward exchange rate$1.75/£ (1 year maturity) To calculate: -Forward market hedge -Money market hedge -Option market hedge (assume $1.80/£ call options cost $0.018 per pound)

What if we want to hedge a ‘minor’ currency? We can partially hedge currencies in which there is an illiquid or non-existant market by cross-hedging with currencies that are closely linked to the minor currency

Hedging recurrent cash flows  If we regularly expect to receive or make payments in a foreign currency we can use swaps to hedge this risk  Essentially swaps are a portfolio of forward contracts with different maturities; can be up to 20 years  Might be able to find a company with nearly-matching opposite cash flows

Operational Techniques

Some natural hedges  Hedge through invoice currency : try to denominate sales/purchases contracts in domestic currency. Need market power to achieve this.  Hedging via lead and lag : lead means to pay or collect early, lag means to pay or collect late. Essentially involves trying to predict movements. Can use forward market for information.  Exposure netting : if company has both receivables and payables in a foreign currency should only hedge net exposure; otherwise might ‘over- hedge’. Centralised depositary helps with this.

Should a firm hedge?

… not necessarily …  Shareholders can hedge the forex risk associated with their company’s cash flows; so corporate level hedging might be redundant  Just reducing idiosyncratic risk, which an efficient investor has already diversified  However this assumes a perfect market and rational investors

Some arguments for hedging… 1. Information asymmetry: management knows the firms forex exposure better than shareholders 2. Differential transaction costs: large scale hedging by a firm is probably cheaper than hedging by an investor 3. Default costs: Corporate hedging can reduce the probability of default 4. Progressive corporate taxes: (doesn’t really apply anymore) but if corporation tax increased with earnings then stable earnings will probably have lower tax than highly fluctuating earnings

On the ground  Hedging is widely used, with a 2001 survey showing 93% of large companies use forwards to hedge currency risk  Studies have shown that companies that use hedging are more highly valued than companies that don’t (Allayannis and Weston, 2001).  Although the presence of hedging might just be a measure of generally better financially run companies